Evan Gatev, Boston College William N. Goetzmann, Yale School of Management, International Center for Finance K. Geert Rouwenhorst, Yale School of Management, International Center for Finance
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Pairs Trading: Performance of a Relative Value Arbitrage Rule
Evan Gatev Assistant Professor Boston College William N. Goetzmann Edwin J. Beinecke Professor of Finance and Management Studies Yale University K. Geert Rouwenhorst Professor Yale University
First draft: June 1998 This version: February 2006
Abstract We test a Wall Street investment strategy, “pairs trading,” with daily data over 1962-2002. Stocks are matched into pairs with minimum distance between normalized historical prices. A simple trading rule yields average annualized excess returns of up to 11 percent for selffinancing portfolios of pairs. The profits typically exceed conservative transaction costs estimates. Bootstrap results suggest that the “pairs” effect differs from previously-documented reversal profits. Robustness of the excess returns indicates that pairs trading profits from temporary mis-pricing of close substitutes. We link the profitability to the presence of a common factor in the returns, different from conventional risk measures.
We are grateful to Peter Bossaerts, Michael Cooper, Jon Ingersoll, Ravi Jagannathan, Maureen O’Hara, Carl Schecter and two anonymous referees for many helpful discussions and suggestions on this topic. We thank the International Center for Finance at the Yale School of Management for research support, and the participants in the EFA’99 Meetings, the AFA’2000 Meetings, the Berkeley Program in Finance and the Finance and Economics workshops at